[FoRK] Shadow banking IS banking - without Federal guarantees
sdw at lig.net
Wed Jan 6 22:47:51 PST 2010
This seems to make sense. Can you tear it apart?
The Real Cause Of The Crash
The financial system may have recreated the conditions that used to make
banking panics the norm.
by Jonathan Rauch
Saturday, Sept. 12, 2009
Malcolm Gladwell, a New Yorker science writer, recently had this to say
about the financial markets' meltdown last fall: "The roots of Wall
Street's crisis were not structural or cognitive so much as they were
psychological." Too many people, apparently, got too cocky. And --
kaboom! -- the whole financial system collapsed!
Sorry. That won't do. No doubt, too many people did get too cocky, but
there is nothing new about cockiness ("animal spirits") on Wall Street.
No doubt, too, inadequate and misguided regulation played a part. No
doubt, also, expansive monetary policy and affordable-housing mandates
were factors. Indeed, many, many factors were factors.
But the core of the problem remains mysterious, even when you add up the
standard explanations. The story most people think they know is that the
Titanic (the financial system) steamed too fast (financiers got
reckless) and hit an iceberg (bad subprime lending), so the ship sank.
The problem with that story is that subprime mortgage lending was a big
number, big enough to cause grief for investors in subprime paper. But
it should not have been nearly big enough to bring the whole financial
system to the brink of collapse.
George Santayana was vindicated: Those who had forgotten history had
been condemned to repeat it.
Moreover, asset-backed securities that had nothing to do with subprime
lending -- paper backed by student loans, auto loans, corporate debt,
credit card debt, regular mortgages, and so on -- also seized up. On the
merits, the crisis should have been sectoral, not systemic. It was as if
the Titanic had missed the iceberg, or was only dented, and then sank
Gary Gorton, a finance professor at Yale, thinks he knows. Unwittingly,
the U.S. financial system recreated the panic-prone conditions that were
the norm in this country throughout the 19th century and into the first
third of the 20th.
Gorton (full disclosure: a personal friend) has been thinking about
financial crashes for three decades. His doctoral dissertation was
titled "Banking Panics and Business Cycles." From 1996 to 2004, as a
consultant to American International Group, he helped develop the math
behind the financial instruments (credit default swaps) that ultimately
brought AIG to its knees. "I spent my entire career studying banking
crises and then happened to live through one," he says.
In a series of recent scholarly papers (one of which he co-authored with
a Yale colleague, Andrew Metrick), Gorton anatomizes the collapse in
fascinating detail. My summary only hints at the richness of the
originals, available online here.
Banking panics are a fixture of American history. At least seven major
ones occurred between 1873 and 1914. Typically, they came at the peak of
a business cycle, when straws in the wind hinted at recession. Although
everyone called bank runs "panics," Gorton stresses that in fact they
were rational responses to an information gap. Depositors knew that in a
recession some banks would fail. But they had no way to know which banks
would fail. So, as a precaution, they would withdraw their money.
When a bank run began, banks rushed to raise cash by calling loans and
selling assets. Distress sales drove down asset prices, which cratered
banks' balance sheets and strangled the flow of credit, which induced
further cash hoarding, which crushed the money supply. The typical
result was a severe recession.
What really needs explaining is not why recurrent financial panics
happened, but why they stopped. In the so-called Quiet Period, 1934
through 2007, systemic bank runs seemed to become relics of an unmourned
past. Why? Because for about four decades, banks' activities were
restricted to heavily regulated ventures that were more or less
guaranteed a profit -- and, even more important, because federal deposit
insurance, which began in 1934, assured depositors that their savings
Financial innovation, however, could be delayed but not denied. Around
the walled garden grew a forest of new competitors and products.
Money-market funds and other investment vehicles took deposits without
offering federal guarantees. In a process known as securitization,
investment banks converted predictable streams of income, everything
from mortgage payments to health club dues, into securities that
investors bought eagerly. Derivatives -- securities based on other
securities--arose to spread risk and hedge against volatility. In time,
shadow banking, as the new institutions and instruments were
collectively called, rivaled and even eclipsed old-fashioned commercial
The firms and major financial players making all these trades needed to
park cash where it would hold its value and earn some interest, yet be
accessible on demand. In other words, they needed the equivalent of
checking and savings accounts, the "demand deposits" that banks
traditionally provide and that form the backbone of the money supply.
But no insured depository could begin to cope with the trillions of
dollars involved. And so shadow banking developed what amounted to its
own depository system, a short-term securities market called the "sale
and repurchase," or "repo," market. It is immense. Gorton figures its
size at perhaps $12 trillion, but he says no one knows for sure.
"It's important to see that this is a banking system," Gorton says. But
it is like a 19th-century banking system, because repo "deposits" are
uninsured. Unable to rely on a federal guarantee, depositors who park
their holdings there require that the borrower put up something of value
Treasury bonds, because they are safe and liquid, are the ideal form of
collateral, but there were nowhere near enough of them to meet the
demand. So asset-backed securities -- those packages of safe-looking
income from mortgages, auto loans, and all the rest -- were pressed into
service as collateral. In time, the better grades of subprime
mortgage-backed securities were mixed into the blend, and they, too, won
acceptance as collateral.
All of these asset-backed securities were sorted and re-sorted, combined
and recombined, sold and resold, until, as Gorton writes, "looking
through to the underlying mortgages and modeling the different levels of
structure was not possible." Users could not independently assess the
value of mortgage-backed collateral any more than your grocer can
independently assess the solvency of your bank before accepting your check.
You can see, perhaps, where this leads. Repo is a form of money because
it acts as a store of value and financial actors rely on it to conduct
transactions. But instead of being backed by a federal guarantee, it was
backed by, among other things, subprime mortgages. In this way, without
anyone paying much notice, subprime mortgage debt entered the money
supply. As in the 19th century, the economy had become dependent upon a
form of bank-issued money that was not federally guaranteed and that was
not as stable as it appeared. Unlike in the 19th century, however, no
one understood how vulnerable the system was to a panic.
Calamity then struck, as it had before. First, the unexpected decline in
housing prices tanked the subprime market. Repo depositors knew that
most collateral was sound, but they had no way to know if their own
holdings were safe; so in 2007 they began what amounted to a run on the
repo system, effectively withdrawing their money. To raise cash, repo
depositories dumped assets, further depressing collateral values and
starting a tailspin.
In September of last year, when the failure of Lehman Brothers, the
mighty investment bank, convinced investors that no one was safe, the
crisis turned into a meltdown. As the repo market "virtually
disappeared" (in Gorton's phrase), the money supply crashed and the
economy began to suffocate. And George Santayana was vindicated: Those
who had forgotten history had been condemned to repeat it.
Whether Gorton has the story right is not something I am qualified to
judge. The meltdown was a seminal event, one that no one, including
Gorton, foresaw and one that will take years to understand. Before the
meltdown, he says, "bank regulation began to not make sense to me. But I
never thought we were going to see an event this big. I'm going to spend
basically the rest of my career trying to sort this out."
Assuming he is right, however, higher capital requirements for big
banks, consumer-protection laws, and other commonly mooted reforms
largely miss the point. The main question, Gorton says, is not how to
strengthen conventional banking but how to stabilize shadow banking,
which means, first and foremost, recognizing that shadow banking is
banking and then asking whether it needs federal insurance,
government-backed collateral, reserve requirements, regular audits, and
other regulatory stabilizers.
"These are the real issues," Gorton says. "It doesn't seem to me that
we're having that kind of discussion."
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